World Journal of Entrepreneurship, Management and Sustainable

Development
A borrowing cost model for effective performance of SMEs in Uganda
Sulait Tumwine Richard Akisimire Nixon Kamukama Gad Mutaremwa
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Sulait Tumwine Richard Akisimire Nixon Kamukama Gad Mutaremwa , (2015),"A borrowing
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Management and Sustainable Development, Vol. 11 Iss 2 pp. 74 - 89
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WJEMSD
11,2
A borrowing cost model for
effective performance of SMEs
in Uganda
74 Sulait Tumwine
Faculty of Vocational and Distance Education,
Makerere University Business School, Kampala, Uganda
Richard Akisimire and Nixon Kamukama
Department of Accounting, Makerere University Business School,
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Kampala, Uganda, and

Gad Mutaremwa
Jinja Study Centre, Makerere University Business School, Kampala, Uganda

Abstract
Purpose – The purpose of this paper is to develop an effective cost borrowing model of qualitative
factors that are relevant to micro and small enterprises (SMEs) better performance.
Design/methodology/approach – A valid research instrument was utilized to conduct a survey
on 359 SMEs (131 retail businesses, 125 service businesses, 48 farming businesses and 55 other
businesses) and 897 respondents that are representative of 397 SMEs and 1,087 respondents.
Correlation and regression analysis were conducted to ascertain the validity of the hypotheses.
Findings – It was established that cost of borrowing elements (interest rate and loan processing costs)
are associated with SME performance. Furthermore, cost of borrowing as a whole accounts for 31.1
percent of the variation in performance Uganda’s SMEs.
Research limitations/implications – Only a single research methodological approach was
employed, future research through interviews could be undertaken to triangulate. Multiple
respondents in SMEs (owner, manager and cashier) were studied neglecting others. Furthermore,
the study used the cross-sectional approach – a longitudinal approach should be employed to study the
trend over years. Finally, cost of borrowing was studied and by the virtual of the results, there are
other factors that contribute to SME performance that were not part of this study.
Practical implications – There is need to intensify initiatives to encourage greater understanding
and acceptance of cost of borrowing, select appropriate elements that includes interest rate and loan
processing costs in order to have affordable source of financing to establish and grow SMEs, provide
employment, competitive and contribute to countries GDP.
Originality/value – This is the first paper in Sub-Saharan Africa to test empirically the relationship
between cost of borrowing and performance of SMEs in the Ugandan context.
Keywords Performance, SME, Cost of borrowing, Interest rate, Loan processing fee, Membership fee
Paper type Research paper

1. Introduction and motivation

World Journal of
Entrepreneurship, Management
and Sustainable Development
Vol. 11 No. 2, 2015
pp. 74-89
© Emerald Group Publishing Limited
2042-5961
DOI 10.1108/WJEMSD-03-2014-0009
Micro and Small Enterprises (SMEs) dominate the business sector in Sub-Saharan
Africa accounting for 60 percent of the total number of enterprises (Nuwagaba, 2012).
In Uganda, the business sector has since 1990’s to-date gained a commendable
8 percent growth per annum contributing 28 percent to Uganda’s GDP and to its
growth by 37 percent (Uganda Bureau of Statistics (UBOS), 2013; Nuwagaba,
2012). According to Nkundabanyanga et al. (2013), Kakuru (2008), Kazooba Charles
(2006), SMEs constitute over 60 percent in low-income countries and account for
41 percent of economic growth in Sub-Saharan African countries for a period between
 1998 and 2010 while the industry sector contributes 25 percent, service sector Performance
30 percent and the agriculture sector 17 percent. Therefore, for Sub-Saharan African of SMEs
countries and Uganda in particular to grow, they need to put emphasis on the business
sector especially SMEs because in addition to their GDP contribution, they create
employment to the skilled, semi-skilled and the unskilled labor, need lower investments
and offer a method of ensuring a more equitable distribution of national income leading
to economic growth and development (Kakuru, 2008). They also increase on national 75
establishment that enables customers get goods and services easily and at reduced
prices because of market competition and competitiveness though the service
and manufacturing sectors benefit countries in terms of trade preferences and
secondary goods (Kazooba Charles, 2006). Despite the great importance attached to
SMEs, they face a challenge of accessing capital to finance their establishment due
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to the high cost attached when it comes to borrowing. This hampers their emergence
and eventual growth (Stiglitz and Weiss, 1981).
The main sources of capital for SMEs is mainly retained earnings, informal savings
and loan associations, which are unpredictable, not very secure and have little scope
for risk sharing because of their regional or sectoral focus (Enterprise Uganda, 2012).
Access to formal finance by SMEs is difficult because of the high risk of default,
poor guarantees, lack of information about their ability to repay loans as well as
inadequate financial capabilities (Stiglitz and Weiss, 1981).
Like other developing countries, Uganda’s, SMEs operate with limited capital cited
in the lack of access to finance as a significant constraint on their operations
(Nuwagaba, 2012). This is often associated with financial policies and bank practices
that make it hard for banks to cover the high costs and risks involved in lending
to small firms. Financial institutions that lend to SMEs have registered high
administrative costs in loan processing and monitoring and yet the return is
low because of small amounts borrowed as well as high risks and default rate since
these business enterprises do not have collateral securities (Kuang, 2008). This has
resulted in financial institutions shifting the burden to SMEs by way of increasing
interest rates, monitoring costs, membership fee to access finances which has affected
their performance. As a result, SMEs find them trapped into vicious cycle of poor
financial performance brought about by high production costs because they operate
on little capital (Kalyango, 2012; Ortiz-Molina, 2007).
The purpose of this study is to develop an effective cost borrowing model of qualitative
factors that are relevant to SMEs better performance. This was necessary because
the financial constraints SMEs are facing (low sales, high production costs and limited
asset base) emanating from limited capital that has resulted into poor product quality,
limited output and market and closure because of competitive pressure. In addition,
understanding the nature of the costs SMEs meet in financing their businesses
is important to management research since it focusses directly on to the costs ought to be;
for better performance (Enterprise Uganda, 2012). Coupled with this, attempts by scholars
have focussed on financial intermediation (Kamukama, 2013), supply and demand factors
for credit (Kakuru, 2008), cause of business failure (Kazooba Charles, 2006) but none of the
studies has provided a suitable cost borrowing model that SMEs and micro finance
institutions (MFIs) can adopt to enable their growth and better performance.
The paper is organized into five sections and begins with the brief overview of
the research study followed by the theoretical reviewed related literature and
hypothesis, methodology, results and discussions, summary and conclusions,
and lastly research implications, limitations and suggested areas for further research.
 WJEMSD 2. Theoretical framework and literature review
11,2 Theoretical review
Kauffmann and Schneider (2004) in his study about financing SMEs came up with
growth borrowing theory which states that financial institutions are determinants in
fostering growth of business enterprises through improved performance in terms
of profitability, level of sales and asset acquisition. Borrowing acts as a financial
76 problem solver to enterprises without enough capital by acquiring loans and paying
them back at a future date literally from the profits generated. The borrowed funds are
invested in productive ventures, which results into profits, part of which are used to
pay back the borrowed money and other requirements by the lender.
According to the transaction cost approach enshrined in the theory of financial
intermediation (Brealey et al., 1977), numerous markets are characterized by
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informational differences between borrowers and lenders. Borrowers typically know

their collateral, industriousness and moral rectitude better than do lenders;
entrepreneurs possess “inside” information about their own projects for which they
seek financing. Lenders would benefit from knowing the true characteristics
of borrowers, but moral hazard hampers the direct transfer of information between
market participants. Borrowers cannot be entirely straightforward about their
characteristics, nor entrepreneurs about their projects, because substantial rewards for
exaggerating positive qualities and verification of true characteristics of businesses/
projects by outside parties is costly or impossible.
By analyzing the above theories, Woller and Schreiner (2006), observed that the
interference of lending institutions was negatively skewed because benefits were found
to be enjoyed by the lenders than the borrowers which limits the growth of SMEs.
This was found to be more applicable to small scale enterprises that access little funds,
with shorter repayment period resulting in high costs of borrowing. The uncertain
nature of SMEs due to unskilled workers, limited capital, has denied them a strong
asset base and face acute competition in accessing capital from commercial banks
who offer capital at a lesser cost. This gap of not easily accessing funds from
commercial banks has been covered by MFIs, which are profit oriented, offer loans to
SMEs by levying several charges that are expensive to SMEs.

3. Literature review
Concept of SMEs and borrowing costs
According to MoFPED (2012) and Najjemba (2004), SMEs are defined based on the
number of persons employed, investment in plant and machinery and sales turn
over. In Uganda, a common understanding of SMEs is an enterprise employing less
than five but with a maximum of 50 employees, with the value of assets, excluding
land, building and working capital of less than Ugx.50 million (US$30,000), and the
annual income turnover of between Ugshs.10 milliom and Ugshs.50 million
(US$6,000-US$30,000).
According to Mwenda and Muuka (2004), financial institutions charge different
costs to borrowers but largely based on market conditions, degree of risks and
institution’s objectives. They include: simple interest which is calculated only on
the principal amount, or on that portion of the principal amount which remains unpaid;
compound interest where the borrower is charged interest on interest unpaid, loan
management fee (insurance cost cover, ledger fees) and membership fee. This has led
to increase in the cost of acquiring loans by SMEs (Youssoufou, 2007).
 According to Prevost et al. (2008), the cost of borrowing which eventually Performance
determines the rate of interest depends on the cost of funds. A large portion of MFIs’ of SMEs
funds are sourced from commercial banks and the cost of these funds is the market
interest rate which is always high. In fact, this financial expense when combined
with the fees paid on such loans and deposits taken, makes borrowing costly to the
SMEs. On the other hand, most SMEs do not acquire loans from commercial banks’
because their terms and conditions are hard and cannot be met (Kasekende, 2003). 77
As a result, they resort to borrowing from MFIs that charge higher interest rates
between 30 and 42 percent than the Development and Commercial banks who charge
between 15 and 22 percent. Based on these comparisons, interest rates charged by
MFIs are high and unfavouarable to SMEs as they significantly increase the
cost of borrowing.
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Interest rate charge

According to Koegh (2006), interest is the cost of loan to the borrower and the income to
the lender calculated on the basis of real interest rate plus inflation, among other factors
of which the lenders cannot ignore. The interest rate that you pay to borrow money
is influenced by numerous factors relating to the type of loan that you choose,
the length of time over which a loan is to be repaid, the collateral, credit history,
and the lender that you select are all important aspects of the interest rate that an
SMEs will be charged. In addition, the cost of borrowing depends on the operation
expenses, level of profits a lending institution expects, the amount of taxes a lending
institution incurs (Nuwagaba, 2012).
Accordingly, increasing interest rates have led SMEs to suffer from constraints that
lower their resilience to risk and prevent them from growing and attaining economies
of scale and therefore remain among the less profitable sector in the Sub-Saharan
Africa (Nuwagaba, 2012; Sander, 2000). In Uganda most SMEs have experienced poor
financial performance leading to their closure within six months to one year
of operation because much of their capital is borrowed and they cannot afford to pay
(World Bank, 2012). This has been attributed to unfavorable credit terms like high
interest rate and other fees charged at the source before a borrower accesses money
from the MFI that finances their businesses (Ministry of Finance, Planning and
Economic Development (MoFPED), 2012). SMEs that persist and invest, their financial
performance have remained poor due to little funds available, accompanied by high
interest rate that increase the cost of doing business since they do not enjoy economies
of scale. As a result, many SMEs have remained using poor technology, producing poor
quality products that are not competitive in the market, employ unskilled and unqualified
workers which has continuously placed them on a weaker financial position (Okurut and
Bategeka, 2006). Because of limited literature on the link between interest rate charged
and performance of SMEs, calls for testing the following hypothesis:
H1. Interest rates charged positively influence performance of SMEs.

Membership fee/contingency fee

According to (Kuang, 2008), high transaction costs are associated with disseminating
and recovering a large number of small-sized loans, often to clients in geographically
dispersed areas with poor infrastructure and security conditions. Based on Wei and Tu
(2009), SMEs normally borrow from MFIs which demand that every borrower must pay
the membership fee; in addition to other costs as a requirement for accessing the loan,
 WJEMSD which according to Kuang (2008), worsens the borrowing appetite of SMEs. This cost is
11,2 taken as a provision for bad debts. In light of Ortiz-Molina (2007) observation,
the provisions for bad debts are often a regulatory requirement for bank-led MFIs.
Such costs are always transferred to borrowers in form of high costs of borrowing and
yet SMEs access small loans which cannot enable them expand to enjoy economies of
scale. Furthermore, Faroque (2007) observe that SMEs operate in uncertain
78 environment with lots of risk, each borrower is insured against death as well as bad
debts and collapse of the business; a cost met by the borrowers that eventually
increases the cost of borrowing which is never paid back to the borrower after his
repayment period. This requirement put SMEs at a dare disadvantage and the studies
so far carried out are silent about the link between membership fee and performance of
SMEs. The researcher therefore sets the following hypothesis:
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H2. Membership/contingency fee positively influences performance of SMEs.

Loan processing costs
Insurance fee. According to Vasiliades (2001), lending institutions have criteria they use
while fixing interest rate among which is insurance fee, deducted from the source
before the loan is disbursed. This is to cater for the period the borrower fails to fulfill
his obligation of paying back the borrowed money due to unclear circumstances.
In light of this, Youssoufou (2007) observed that there should be credit insurance that
pays some or all of a loan back when certain things happen to the borrower such as
unemployment, disability, or death, and to MFIs, such funds are met by the borrowers
that end up increasing the cost of borrowing. It, however, remains befitting because
whether a borrower pays all principle and the interest; he is not refunded the insurance
fee deducted. This worsens the financial situation of SMEs (Wei and Tu, 2009).
According to Westover (2008), the essence of insurance fee is to protect individuals
and companies against various financial risks, such as loss of sales if fire in a factory
prevented it from carrying out its business for a time and failure of a creditor to pay
money he owes to the insured. It is due to such risks involved that MFIs tend to charge
insurance fee but risks well knowing that their main customers are SMEs that operate
in risky environments that pause a threat to their businesses and therefore threatening
loan repayment.

Loan management fees

The business of financial institutions is to manage financial risk emanating from either
credit, transactional, liquidity and operational risks. MFI’s must invest heavily in the
development of a methodology that reduces either risks to the borrowers because they
depend largely on the un secured clients deposits for their operations especially as
a source of loan fund. MFI’s are thus forced to charge a certain fee (management fee)
to increase on the cash pull for the next borrower; and act as a commitment that
will overcome both credit and liquidity risks.
According to Vasiliades (2001), credit risk is the risk to earnings or capital due
to borrowers late or non-payment of loan obligation that may lead to MFI’s inability to
collect anticipated interest earnings and the initial amount disbursed. The study
conducted by Omeka (2007) conclude that the credit gap can be bridged by providing
for the loan management charge to the borrowers to cater for peer monitoring and other
associated costs. However, this has not yielded any fruit because the portion charged is
not adequate to monitor a borrower in addition to increasing the financial problems.
 More so, Najjemba (2004) observed that loan management includes management of Performance
liquidity risk which is the possibility of a negative effect on the interest of owners, of SMEs
customers and other stakeholders of the financial institutions resulting from inability
to meet current cash obligations in a timely and cost-effective manner. However,
liquid cash may not pay interest to those clients who will have saved in anticipation of
an interest on their saved money in addition to scaring away borrowers. According to
Omeka (2007), liquidity risk arises from management’s inability to adequately 79
anticipate and plan for changes in funding sources and cash needs. Efficient liquidity
management requires maintaining sufficient cash reserves on hand to meet client
withdrawals; disburse loans and fund unexpected cash shortages while also investing
as many funds as possible to maximize earnings. This can be achieved by MFIs
charging a fee and offer shorter payment periods to the borrower. This charge reduces
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on business profits, are unable to acquire assets and recruit competent workers
to foster their growth. With the studies so far carried out, they are silent on the linkage
between loan processing and performance in the SME literature. In light of this,
the researcher hypothesis as follows:
H3. Loan processing costs positively influences performance of SMEs.

4. Performances of SMEs
According to Westover (2008), performance is taken to be the function of an
organization’s ability to meet its goals and objectives by exploiting the available
resources in an efficient and effective way. In a related case, John (2004) establishes that
performance entails the firm’s ability to serve and produce what the market requires
at a particular time and meeting its objectives at the lowest possible cost with the
highest possible benefits. In order to assess performance, managers use actions
designed to generate sustainable long-term improvements (Alexander et al., 2008).
Campbell (2004) observed that organizational performance measures must focus on
what makes, identifies and communicates the drivers of success, support organization
learning and provide a basis for assessment and rewards. To Kasekende and Opondo
(2003), performance is seen in terms of competitive performance, financial performance,
and quality of services, flexibility, resource utilization and innovation.
Furthermore, Kuang (2008) stated that appropriate performance measures are those
which enable organizations to direct their actions toward achieving their strategic
objectives. Koegh (2006) suggests that performance should be looked at in terms of
economy, efficiency and effectiveness. Accordingly, economy is acquiring resources in
appropriate quantities and at the least cost while efficiency is maximizing inputs for
a required output or the extent to which the defined task has been accomplished and is
consistent with notions of non-financial accountability and measured in terms of
quality of service, customer satisfaction and achievement of goals. Based on the
prevailing literature, performance of SMEs will be measured based on liquidity, sales
level and asset base.
Liquidity as a measure of organizational performance
According to Maes et al. (2000) liquidity relates to the settlement of short-term debts
arising from the day to day operations. In the case of SMEs struggling to survive,
liquidity is a very important indicator of the state of financial health. As William puts
it, liquidity is the degree to which debt obligations coming due to next 12 months can be
paid from cash or assets that will be turned into cash. Teszler (1993) concurred with
 WJEMSD Okurut and Bategeka (2006) that a firm’s liquidity is a good indicator of good financial
11,2 performance. Ferreira and Vilela (2004) established that the growth opportunities
in SMEs is highly attributable to its liquidity and is thus an important factor that
positively affects cash levels. Therefore, SMEs with more growth opportunities may
incur greater costs of financial distress because their value depends on their liquidity
rather than tangible assets or specific cash flows.
80 However, Kappel and Steiner (2004) concluded that SMEs size is significant in
determining liquidity levels. The traditional models to determine the optimal liquidity
demonstrate that there are economies of scale associated with the cash levels required
to confront the normal transactions of the SMEs, so that as they grow, they can keep
lower cash holdings.
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Level of sales as a measure of performance

According to Johnson and Tian (2000) and Kasekende and Opondo (2003) sales volume is
considered a good measure for performance of SMEs; when sales increase, turnover is
bound to increase. This implies that the business is expanding its level of output,
an indicator of better performance. Thus, if sales volume is increasing, the productive
capacity of the business expands and it eventually enjoy economies of scale that enables
it to produce at reduced costs, sell its products cheaply and becomes competitive in the
industry. According to Bagozzi (1999), a business is said to be performing better if its
sales volume is increasing and in situation where there is efficient business management,
sales volume and revenues are bound to increase which enables its liquidity thereby
reducing on the business capacity to borrow in order to meet its debt obligations. In
contrast to Bagozzi’s conclusion, as a business grows, its appetite to borrowing increases.

Asset base as a measure of performance

One of the successes of any business venture is the level of assets it accumulates over
time and according to Johnson and Tian, the expansion of a business is measured in
terms of the rate at which its assets are growing and being used, leading to enjoyment
of economies of scale and hence being competitive in the market. Campbell (2004) in his
study confirmed Johnson and Tian’s observation that it is the increase in the assets that
indicates effectiveness and efficiency of a business’s performance. He further noted that
a business with strong assets is capable of accessing loans from financial institutions
cheaply since such assets can act as collateral security. However, William found a weak
correlation between borrowing and increase in asset base by SMEs. For example,
young businesses access very little funds from the financial institutions at very high
cost yet the returns to these enterprises are low and thus not able to increase their
investment to increase on the asset base. However, William’s criticism did not provide
the direction of that relationship on whether they should borrow or stop borrowing and
if they stopped, what would their source of financing. This study therefore will explore
this to find out the direction of relationship.

Cost of borrowing and performance of SMEs

Entrepreneurs and small business owners often turn to loans in order to establish or
expand their business ventures. Business enterprises that choose this method of
funding (debt financing) need to be aware of all components of loan agreements,
including the interest, loan processing cost and membership fee. Studies by
MoFPED (2012) and Kappel and Steiner (2004) have linked the cost of borrowing
 to performance. They assert that the cost of borrowing which is a component Performance
of operating expenses, profit motive and inflation rate significantly affects the of SMEs
performance of SMEs. This is measured in terms of output, level of revenue and
employment depending on how the borrowed money is put to use.
According to Kappel and Steiner (2004), the cost of borrowing is not a problem as
long as the borrowed money is invested in ventures with high rate of return, but for
this to be achieved; enough capital should be accessed by the borrowers to increase on 81
their levels of investment so as to enjoy economies of scale. Their findings were in
agreement with who found out that loan performance is influenced by the loan size and
loan repayment period.
According to MoFPED (2012) a high interest rate regime with shorter loan
repayment period undermines the financial performance of SMEs through increased
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probability of default and non-performing assets that affect liquidity. It further

threatens the financial long-term solvency of private sector businesses and especially of
local origin, mainly SMEs. Moreover as a result of compounding, a continually rising
interest rate increases loan repayment obligation over time and constrains SME
operations. The high cost of credit and the small loans available not only affect private
sector business through increased costs of operation, but also affect productivity with
its associated effect on liquidity and profitability of the enterprises (Wright, 2000).
However, much as the cost of borrowing induces commitment to the productive use
of the loan so as to repay, it in turn leads to improved financial performance of the
organizations. In support of this, empirical literature, Youssoufou (2007) revealed that
subsidized credit in Burkina Faso cooperative banks constantly encouraged borrowers
to engage in high productive activities which in turn led to relative financial
performance of their businesses. In addition, Koch and MacDonald (2000) provides
that the financial stability of Belgian banking sector as well as principles of
management and supervision of interest rate risk greatly contribute to the survival of
many financial institutions and SMEs. Similar explanation in Bank of International
Settlement (2004) as published by Basel Committee on bank supervision provides
that interest rate management is critical to the survival of most financial institutions.
Following the reviewed literature we hypothesis as follows:
H4. Cost of borrowing positively influences performance of SMEs.

5. Methodology
Design, population and sample
The study used a cross-sectional, qualitative and quantitative research designs to
address the stated hypotheses. The study population included 48,897 registered SMEs
in Uganda (UBOS, 2013). The sample size of 397 SMEs with 1,087 respondents was
generated using Yamane (1973). According to Yamane (1973), the sampling tables
indicate that with this range and at precision levels of ±5 percent (confidence level
of 95 percent, p ¼ 5), the average sample becomes 397 objects, at precision level of
±3 percent (confidence level 97 percent, p ¼ 3) the sample becomes 1,087 objects and at
±7 percent (confidence level 93 percent, p ¼ 7) it becomes 204 objects. We took the first
and second level of 397 SMEs at precision level ±5 percent and 1,087 respondents
(owners and employees) at precision level of ±3 percent which was representative
enough for such population and it fairly yields better results. Besides, the sample size
generated using this approach fairly mirrors the results one would have got using
a table of random samples by Krejcie and Morgan (1970). Stratified and purposive
 WJEMSD sampling techniques were used based on a business that was in existence for the last
11,2 two years and employs between five and 50 employees and whose capital base is
between US$10,000 and US$30,000.
The unit of analysis was SMEs and owners and employees acted as units of inquiry.
The developed SMEs strata included 144 retail businesses, 142 service businesses,
53 farming businesses and 58 businesses were grouped as others. Out of the employees
82 and owners targeted per SME, three respondents (owner, manager and cashier) were
studied. The decision to accept a minimum of three respondents per business was
based on previous scholars such as Baer and Frese (2003) and Ngoma (2009).
By opting for this methodological approach, perfect information symmetry is
ensured as such respondents are perceived to know how the business operate,
is financed and the performance of the business. Such symmetry of information could
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not be as easily achieved by collecting data from other stakeholders such as the public
and other lower workers for instance shop attendants, store keepers because they were
presumed to have little information regarding the subject matter.
The study variables were operationalized based on previous studies. In addition,
a five-point Likert scale developed by Rensis (1930) was adopted for all item scales
ranging from 1 – strongly disagree to 5 – strongly agree. Cost of borrowing was
divided into three: interest rate, membership fee and Loan processing costs.
Each division was measured basing on the works of other scholars and modified
to match the Ugandan study context.
The questionnaire was validated through expert interviews and by a panel of expert
practitioners and was then physically delivered to the selected respondents at their
work premises on appointment. A survey was adopted as the most appropriate method
of data collection and previous research supports the reliability and validity of the
self-report measures (Lechner et al., 2006). This approach consists of a selection of key
information providers by virtue of their position, knowledge and information available
(McEvily and Marcus, 2005).

6. Results and discussion

Sample characterization
Data from 359 SMEs (897 respondents) out of the targeted 397 (1,087 respondents) was
received representing an average response rate of 91 percent (131 retail businesses,
125 service businesses, 48 farming businesses and 55 other businesses). The larger
number of the respondents were males (512) representing 57 percent and females (385)
representing 43 percent; 36 percent (319 respondents) had a bachelor’s degree as the
highest qualification, 41 percent (371 respondents) had a diploma, 12 percent
(111 respondents) had a certificate and the rest 11 percent (96 respondents) had no
formal qualification. The majority the businesses, 67 percent (241 businesses) had been
in operation for a period of more than five years while the rest 33 percent
(118 businesses) had been in operation for a period less than five years. The main
source of financing for SMEs; 40 percent were borrowing from MFIs, 28 percent were
personal savings, 19 percent from friends and 13 percent borrow from commercial
banks. The mean score of the element of cost of borrowing (interest rate, membership
fee and loan processing costs) and performance were established as 4.2, 3.9, 3.8 and
4.1 and the standard deviation of 0.56, 0.67, 0.74 and 0.76, respectively, and the CVI
were established as 0.87, for the cost of borrowing and 0.77 for performance. Given that
the standard deviations are small compared to mean values, it is true that the computed
 means highly represent the observed data. In effect, the calculated averages are a good Performance
replica of reality (Field, 2006; Saunders et al., 2007). of SMEs
Additionally, descriptive statistics were performed to assess whether borrowing
terms provided by lending institutions to SMEs were favorable. The results showed
that majority of the SMEs do not afford the rates of interest as borrowing costs when
applying for the loans from financial institutions/SACCO’s (Mean ¼ 1.43, SD ¼ 0.605),
membership fees is not promptly paid (Mean ¼ 2.32, SD ¼ 0.940), many continue 83
to borrow from financial institutions even when the cost of borrowing is unfavorable to
them (Mean ¼ 2.23, SD ¼ 0.714) because they do not have any other source of finance.

7. Correlation results
Principal component analysis was used to extract the factors that measured cost of
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borrowing provided by lending institutions whose results are; interest rate 15.7 percent,
membership fees 17.7 percent and loan processing cost 18.4 percent, explaining
51.8 percent of the borrowing costs while the measurement of performance yielded
three factors interpreted as profitability 32.1 percent, liquidity 25.6 percent and asset
base 14.5 percent explaining 72.2 percent of SMEs performance.
The findings in Table I, reveal a significant and positive correlation between interest
rate charge and performance (r ¼ 0.434, **p o 0.01; significant at 0.000) supporting of
H1. In view of interest rate charged, results indicate that levying interest rate on
borrowing is a source of capital for MFI’s and at the same time a source of value to the
performance of SMEs. This is because after making an investment by the owners,
they need to manage other operating costs that would take away the available little
gross profit, for example, cost human capital and marketing among others. In addition,
managers have to work hard, be mindful of what they produce, whom they produce for;
all in line of increasing turnover. This stimulates growth and a return to the
shareholders. This finding is supported by the transaction cost theory (Brealey et al.,
1977), which posits that borrowers know why they borrow and where they are going to
invest the money than the lenders do. In addition, Kappel and Steiner (2004) observe
that interest charged is not a problem as long as the borrowed funds are invested in
ventures with high rate of return. This view point is consistent with Nuwagaba (2012),
who argued that SMEs that can minimize on operating expenses than interest charge,
employ better methods of business management, borrowing would not be a problem.
In addition, results for testing H2 revealed a positive but with no significant
relationship between membership fee and performance (r ¼ 0.211; significant at 0.058).
Arising from this study result, it is clear that membership fee is not an important factor
in influencing performance of SMEs thus rejecting H2. This implies that a positive
change in membership charged to the borrower does not improve performance of
SMEs. In this case, routine requirement of every new borrower to buy shares in a MFI

Cost of borrowing indicators Correlation with export intensity Comment

H1 Interest rate charged 0.434 (0.000)** Supported

H2 Membership fee 0.211 (0.058)** Not supported
H3 Loan processing fee 0.359 (0.001)** Supported
H4 Cost of borrowing 0.440 (0.000)** Supported Table I.
Note: *,**Significant levels at p o0.05 (95 percent) and p o0.01 (99 percent), respectively Correlations results
 WJEMSD to be a member and then borrow, discourages SMEs from accessing loan able funds
11,2 which is a source of underperformance of Uganda’s SMEs because of limited capital.
This is an industry where borrowers (SMEs) endure all conditions in order to access
finances especially if they are in desperate need for money, they agree for the deduction
to cover membership fee which later affects their return on capital employed. However,
this finding contradicts the conclusions of Ortiz-Molina who found out that positive
84 and significant relationship exists between membership fee and performance of SMEs.
The divergent result in this study could be attributable to the nature of the clients and
the businesses they undertake especially in Uganda’s environment. For example, in this
era of economic hardship and competition, majority of the borrowers in Uganda are to
see what they exactly get in relation to what they applied for, because at application,
they had ascertained how much they need and what for. Thus, deducting ones money
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from the source to cover membership fee means that the borrower will not have enough
to do what the business want according to the business plan, this may result in multiple
borrowing or diversion of funds. In this case, SMEs need not to be charged membership
fee if they are to be better served by MFI’s; instead, the performance of SMEs will be
influenced by the amount of money applied for in full. Nevertheless, SMEs dealing in
agriculture (Nuwagaba, 2012) membership fee is paramount because they access the
loans at lesser charges in addition to huge loan amount they take, they therefore should
contribute to their existence and that of MFI’s from whom they borrow.
The result of testing H3, indicate a positive and significant correlation between loan
processing costs and performance (r ¼ 0.359, **p o 0.01; significant at 0.001).
The result indicate that loan processing fee is an important factor in influencing
performance of SMEs. This implies that a charge to the borrower to process the loan
leads to faster access of requested funds leading to earlier capital investment, hence
improved performance of an SME. This finding is in agreement with observations
made by Omeka (2007), who established that processing costs such as insurance
provide a cover to the borrower in case of default especially in difficult situations where
the business is unable to pay back the borrowed money. Also, a study by Youssoufou
(2007) in Burkinafaso concluded that processing costs motivate managers and owners
of SMEs to work extra harder in abide to recover that cost which the efforts and
resources into ventures that create value and sustainable performance. Therefore,
the findings of this study affirm that loan processing cost in necessary for the best
performance of SMEs and this supports H3.
The result of testing H4 indicate a significant and positive correlation between cost
of borrowing performance of SMEs (r ¼ 0.440, **p o 0.01; significant at 0.000).
This result means that favorable borrowing costs (interest rate and loan processing
costs) now and tomorrow are a source of performance that compels management of
SMEs to work extra to pay the borrowed money amidst the mark up. In the
Ugandan perspective, people work hard when there is an obligation to discharge,
therefore because there is a cost inflicted on the capital borrowed which must be
paid, it forces management to work to pay it back (initial capital and other costs of
borrowing) and at the same time retain something to justify their stay in business.
This justification amounts to improved financial performance (profitability, liquidity
and asset base).

Regression results
Regression results in Table II show that cost of borrowing contributes 31.1 percent of
the variance in performance of SMEs. This indicates that the three borrowing cost
 Performance
Coefficientsa
Unstandardized coefficients Standardized coefficients of SMEs
Model B SE β t Sig.

1 (Constant) 1.537 0.529 2.790 0.000

Cost of borrowing 0.357** 0.153 0.357** 7.219 0.000
R2 ¼ 0.251 85
Adjusted R2 ¼ 0.311
F-statistic ¼ 16.412
Sig. ¼ 0.000
Notes: aDependent variable: SMEs performance. *,**Correlation is significant at the 0.05, 0.01, Table II.
respectively Regression results
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elements studied account for 31.1 percent of the charges to the SMEs signifying that
the remaining 68.9 percent is explained by factors not addressed in this study.
In a related manner, cost of borrowing elements has different weights to performance.
This finding is consistent with observations of Nuwagaba (2012), Koch and MacDonald
(2000) and Youssoufou (2007) who established that the importance of the borrowing
cost elements to SMEs performance is always diverse and the disproportion in the
contribution of individual borrowing cost elements to performance is influenced by
the business industry.

Summary and conclusion

Emanating from the foregoing discuss, the study confirms that, with exception of
membership fee, the rest of the borrowing cost elements (interest rate and loan
processing fee) are significant predictors of performance in the SMEs of Uganda. Of the
three borrowing cost elements, interest rate charge has the highest correlation and
therefore is more important in influencing performance of SMEs. A combination of all
borrowing cost elements predicts 31.1 percent of the variation in performance of SMEs.

Implications for management and researchers

Managerial implications. The study has introduced a comprehensive understanding of
the effect of cost of borrowing on performance of SMEs. This promotes management
effort of both SMEs and MFIs to improve on their performance that can be facilitated
through the necessary reduction in the interest rate and loan processing costs in a more
economical and efficient way taking into account the inflationary pressure.
The management on either side (SMEs and MFIs) need to encourage greater
understanding and acceptance of the cost of borrowing mix that results in the
creation of improved performance, promote economic growth and provide employment
in developing countries.
Since SMEs are meeting a number of costs when accessing the loans that are
becoming prohibitive and making the operation costs high and eventually affecting
their performance, financial institutions should devise a mechanism that can enable
them cut the cost of their operation with the intention of cutting down the cost of giving
out loans. This will attract more borrowers who are capable of utilizing the borrowed
money, make profits and be able to pay back. In this way, both the SMEs and financial
institutions will achieve their objectives of better performance.
 WJEMSD Since borrowing makes SMEs remain liquid due to continuous borrowing,
11,2 they should avoid having excess liquidity at hand. The excess quick assets should be
invested in more profitable ventures. This will eventually enable them build asset base
and reduce their financial dependency from financial institutions for funds.

86 Theoretical implications
The study has addressed practical issues that have not been attended to for long by
both literature and by practitioners and has further shown that cost of borrowing is
essential for the survival and performance of SMEs in addition to the employment they
provide, improvement in GDP among others. Thus, the study has contributed to the
on-going debate concerning the cost of capital in the field of sources of business finance
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and performance.
From the literature, scholars have different views concerning cost of borrowing and
business management dimensions. This study has brought out the key cost of
borrowing elements (interest rate and loan processing cost) as crucial elements if
an SME is to borrow to attain performance. This therefore widens the literature on cost
of borrowing.

Limitations of the study

The findings of this study have some limitations that provide the initiatives for future
research; and some of these include:
• Due to the confidentiality of the required information, the data provided
were based on business owners, manager and cashier who self-reported on their
own SMEs. Therefore, the measures were not based on raw data.
• A single research methodological approach of data collection was used
(structured questionnaire). This limited respondents’ scope of answering
since their views were predetermined.
• Third, a multiple regression for cost of borrowing elements was done producing
a single percent for all the studied components. In addition the result
(31.1 percent) for cost of borrowing is relatively low an implication that there are
other components that contribute to performance that needs a further study.
• Finally, the present study is cross-sectional; it is possible that the views held by
individuals may change over the years.
In spite of the limitations, policy makers dealing with service provision, academicians,
politicians, heads of MFIs, SMEs and general public interested in the field of cost of
borrowing might find this study important.

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Corresponding author
Sulait Tumwine can be contacted at: stumwine@mubs.ac.ug

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